Rail Companies in Mad Rush to Meet Demand for Domestic Crude Oil

Investors in U.S. railway companies are in for a treat as demand for domestic crude oil transportation increases exponentially against the backdrop of an unprecedented surge in shale oil production. While the huge increase in supply of shale oil from the Bakken formation (spanning across the states of North Dakota, South Dakota, Montana, and Saskatchewen) has hurt oil producers as prices adjust downwards, railway companies have benefited as refiners on the East Coast and the Gulf Coast replace relatively pricier imported crude oil with domestic supply.

Traditionally, U.S. refineries have largely relied on imported crude oil pegged to internationally traded crude oil prices. The largest concentration of refineries in the U.S. are based in the Gulf Coast, and the typical product chain has always been to import foreign crude oil as raw materials and subsequently transport the processed oil products by pipeline to customers in the North.

However, new drilling methods and technical capabilities in shale oil production have dramatically increased the production and supply of crude oil on continental U.S. in a very short span of time. As a result, prices of domestic crude oil have tumbled and then decoupled from prices of internationally traded crude oil. To illustrate the difference, the U.S. domestic oil benchmark, West Texas Intermediate, traded yesterday at US$96.91 while the internationally traded Brent crude oil benchmark stood at US$115.53.

This significant difference (or "spread" in industry parlance) between the prices of domestic and imported crude oil has driven many U.S. refineries to look for ways to transport the relatively cheaper crude oil from the Midwest. Because there are no existing pipelines connecting the shale oil production zones such as the Bakken formation to the refinery centers, railroad has emerged as the favorite form of transportation for many companies. This sudden change in market dynamics has in turn driven up demand for railway companies to transport crude oil within the United States.

For example, the Association of American Railroads reported that the biggest U.S. railway operators have seen an increase of more than 30 percent in carloads of crude oil carried just from 2011 to the first half of 2012. To further illustrate the point, the first six month of 2012 saw operators moving 88,026 carloads of crude oil compared to less than 10,000 carloads in 2008.

In another positive sign for the industry, BNSF Railway announced in the first week of September that it plans to expand its crude oil transportation capacity in 2012 to a million barrels per day from the Williston Basin in North Dakota and Montana. CSX Corp, another major rail player, reported earnings growth in its second quarter ending June 30 despite decreasing demand for other forms of energy transportation such as coal.

The resilience of the industry despite the poor economic backdrop and the potential growth in domestic crude oil transportation should entice investors to take a closer look at the domestic railway companies.

1. CSX Corp (NYS: CSX) Based in Florida, CSX is a railway company that serves largely the Eastern Coast of the United States with more than 21,000 miles of track. Its rail network includes 23 states, Washington, D.C., and the Canadian provinces of Ontario and Quebec. It also has over 4,000 locomotives and 80,000 railcars. While coal prices have taken a dip in recent months because of low natural gas prices (a substitute energy source), most of its coal shipments are on annual contracts that will limit the amount of fluctuation in revenue quarter-on-quarter. Management continues to target a dividend payout ratio of 30% to 35%, and CSX is on a share buyback program that will see $400 million worth of purchases by the company that will bring the company's share count down.

2. Union PacificUnion Pacific is headquartered in Omaha and operates in the western two-thirds of the United States. The company has more than 30,000 miles of railroad covering 23 states and linking the Pacific and Gulf Coast Ports with cities from San Francisco to Chicago. Its coal carloads are expected to decrease by 10.2% in the third quarter this year as coal prices remain stubbornly suppressed. However, shale crude oil production and related drilling demand discussed above have continued to provide strong support for Union Pacific's business.

3. Canadian National Railway (NYS: CNI) With its operating ratio consistently more than 60%, CNI is the most efficient and profitable railway company in North America. It is also the continent fifth largest railway company as measured by revenue and connects the Port of Prince Rupert in British Columbia, Canada, to the Port of New Orleans in Louisiana. CNI's railroads extends to the east coast of Canada up till Halifax, with a total network of more than 20,000 miles, 1,839 locomotives, and 70,236 freight cars. Less than 10% of its revenues are generated from coal related activities, while merchandise shipments make up 52% of its revenue.

4. Norfolk SouthernBased in Norfolk, Virginia, Norfolk Southern provides rail transportation services in the eastern U.S. with more than 21,000 miles of track and serving 22 states and Washington D.C. Its rail network is most extensive in the East and extends as far to Kansas City, Dallas, and New Orleans. In FY 2011, 19% of its revenues came from the intermodal business, 31% from coal, 12% from chemicals, and 7% from automotive transportation. Norfolk has a fair amount of exposure to the auto industry as it serves 24 assembly plants -- 14 of which belong to Ford, Chrysler, and General Motors.

5. Canadian Pacific Railway (NYS: CP) Canadian Pacific is based in Calgary and operates a transcontinental railway in Canada and the United States through its network of more than 14,000 miles of railroad. It serves cities such as Montreal and Vancouver in Canada and also operates in the U.S. Northeast and Midwest. Port access includes New York, Philadelphia, Montreal, and Vancouver. It operates in diverse segments, with FY 2011 revenue generated from intermodal (26%), grain (22%), industrial and consumer products (20%), coal (11%), sulfur and fertilizers (11%), automotive (7%), and forest products (4%). Its latest reported quarter also saw new CEO Hunter Harrison facing questions from analysts during the earnings call. Harrison expects to be focusing on improving upon the existing business model and does not expect to make many changes. However, he did announce a lofty target of achieving an operating ratio of 60% in four years, driving the stock up more than 5% on the day of his announcement.

6. Kansas City Southern (NYS: KSU) Headquartered in Kansas City, Missouri, Kansas City Southern was founded in 1887 and operates in 10 states in the Midwest and Southeast region of the United States. It is focused on the North South freight corridor and has the shortest route between Kansas City and major ports on the Gulf of Mexico. In total, it has more than 6,600 miles of railroad that extends directly into Mexico. Its 2005 acquisition of Mexico's largest railroad, Grupo Transportacion Ferroviaria Mexicana, created a NAFTA railway that linked commercial and industrial centers in the U.S., Canada, and Mexico. In FY 2011, 55% of its revenue was generated from the U.S. and 45% from Mexico.

Kapitall's SiHien Goh does not own shares of the companies mentioned above. To see the original article, please visitKapitall Wireorclick here.